Uncertainty, Investment, and Industry Evolution

Ricardo J. Caballero and Robert S. Pindyck

August 1992

Ricardo J. Caballero and Robert S. Pindyck, August 1992

We study the effects of aggregate and idiosyncratic uncertainty on the entry of firms, total investment, and prices in a competitive industry with irreversible investment. We first use standard dynamic programming methods to determine firms\' entry decisions, and we describe the resulting industry equilibrium and its characteristics, emphasizing the effects of different sources of uncertainty. We then show how the conditional distribution of prices can be used as an alternative means of determining and understanding the behavior of firms and the resulting industry equilibrium. Finally, we use four-digit U.S. manufacturing data to examine some implications of the model.

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